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The Most Important Investing Lesson of All

It's something every fourth-grader should know.

Good news: There's a secret out there that can make you a better investor. You'll make more money, pay less in taxes, and spend less time stressing about the daily moves of your stocks.

Sounds great, right?

Even better, you already know this little secret. In fact, you learned it in the fourth grade. And despite its simplicity, it can give you a huge advantage over Wall Street pros -- because they all but ignore it.

What is it?

You won't believe how easy it isThe little secret that can truly make you a more successful investor and give you a leg up on Wall Street is an understanding of the principle of compounding. And before you scoff, realize that if all investors understood the principle of compounding, we'd act very differently when it comes to managing our portfolios. For example, we wouldn't:

Check our stock tickers on an hourly, daily, weekly, or even monthly basis.

Pay so much attention to shows like Mad Money that focus on short-term analysis.

Trade more than a few times each year.

It's sad to work in an industry that makes so much money by getting investors addicted to these bad habits. If there's one thing I'd change about the financial-services industry, it would be to silence the noise and focus on the numbers.

Alas, that won't happenBut just because the financial industry won't change, it doesn't mean you have to play its game. And I'm not advising you to stop checking in on your stocks; that's part of the fun of investing.

What I am advising, however, is to remain cognizant of the fact that the serious money in the stock market is made by investors who have four things:

Time.

Patience.

A commitment to adding new money on a regular basis.

A portfolio of great stocks.

With those four things in place, you will rarely trade and therefore rarely have to pay transaction costs or taxes on earnings. And because your earnings stay in the stock market, those earnings will have earnings, and those earnings will have earnings, and so on.

A better wayShelby Davis, a man who was by no means a master stock picker or market timer, amassed a nearly $900 million fortune over his lifetime simply by buying shares of great companies and holding them indefinitely. That's a successful strategy you can replicate.

Let's say, for example, you invested $1,000 in each of the seven large caps with the lowest P/E ratios 10 years ago. Here's what you'd own, and what those $1,000 positions would be worth today:

Company

Current Value

Ford (NYSE: F)

$229

Hartford Financial (NYSE: HIG)

$1,647

General Motors (NYSE: GM)

$485

AMR (NYSE: AMR)

$189

Dow Chemical (NYSE: DOW)

$1,804

CIGNA (NYSE: CI)

$2,351

Caterpillar

$3,526

Total Annualized Return

3.9%

S&P 500 Annualized Return

4.0%

While this simple, lazy strategy would have merely matched the market's return over the past 10 years, you would have more than doubled the market's return by avoiding Ford, GM, and AMR -- three companies suffering from onerous debt loads in cutthroat industries.

The best way
The way to do best is to buy the best stocks and avoid the duds. And that's where our Motley Fool Stock Advisor investment service may be able to help you. Fool co-founders David and Tom Gardner have made it their mission to identify superior companies that you can buy to hold and hold -- companies that will absolutely crush the market over time. In addition to companies that have strong balance sheets and wide market opportunities, these are companies that are:

Owned by other great investors.

Built to last for 100 years or more.

Little-known, yet dominating their growing industries.

Steered by committed management teams.

Governed by the highest corporate values.

If that sounds like the kind of company you'd like to have anchoring your portfolio for the next decade, click here to join Stock Advisor free for 30 days. You can read about all of our recommendations, see our returns, and decide whether the principle of compounding can help you make a fortune.

This article was originally published Nov. 21, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Dow Chemical is an Income Investor pick. The Fool's disclosure policy used to do a little, but a little wouldn't do it, so a little got more and more.